by Joseph Pescatello

Created on: August 15, 2008   Last Updated: January 08, 2009

Trading stock options allows the investor to control blocks of shares at a fraction of the costs of actually owning the shares themselves. And, unlike share ownership, some option plays allow you to benefit when the price of the stock drops. But options can be highly risky and some strategies leave the investor open to substantial losses. This article describes an option investment play called the 'Straddle' that limits an investors risk and makes money when the stock moves either up or down.

Options Primer

There are two types of options - calls and puts. A 'call' option is the right to buy a stock at a particular price called the 'strike price'. Conversely, a 'put' option is the right to sell a stock at a certain price, also called the 'strike price'. If you believe a stock's price is going to rise, you buy calls on it - if you think teh stock price is going to decline, you buy puts.

Here's a call scenario. XYZ Corp is trading at $10 per share and you're convinced that it will trade at $13 per share within the next three months. So you buy 3 call options with a strike price of $13 and that expire in 90 days. Options trade in blocks of 100, so if you buy 3 calls, you're buying the right to buy 300 shares of XYZ Corp. The calls cost you $1.50 per underlying share so your outlay is $450. If you don't sell or exercise the options before they expire, they will be worth nothing and you will lose your entire outlay. But you aren't going to let that happen!

Basically, if the price of XYZ goes up while you own the calls, the value of your options also goes up. You can sell the options at any time before they expire, or you can exercise your right to buy the shares at the strike price if you want to. So if XYZ goes to $15 and there's still a good amount of time left before the options expire, the calls might shoot up in value to $5 or more. That's about a 360% return on your investment! But if the stock remains around 10 or declines, your call options will decline in value and will expire worthless if the expiration date arrives and the share price is lower than the strike price.

In a put scenario, lets say you believe that XYZ Corp is overpriced at $10 and you believe that it will drop to $8 within 90 days So you buy 3 put options with a strike price of $10 and that expire in 90 days. These options are trading 'at the money', that is, the strike price is right at the current share price so you are paying only for the 90 days time value. Let's say the puts cost you $1 per

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